If you live to the end of the specified period, the residence, including all post-gift appreciation, passes to the children free of any additional federal estate or gift taxes. However, one disadvantage is that if you die before the end of the period, the value of the residence, as of the date of death, will still be includible in your estate for federal estate tax purposes .The result in that case is the same as if you had never created the QPRT. Therefore, for maximum benefit and results, you need to outlive the term of the trust.
A second disadvantage of the QPRT is that if the house continues to be a part of the trust after the initial term ends, it will pass to the remainder beneficiaries with your original income tax basis.
What is the Disadvantage of Passing the House to My Children with My Original Income Tax Basis?
For the sake of illustration, let’s say that you bought your house for $50,000 and lived in it for 30 years without putting any more money into it. After 30 years, you decide to sell it, and you are paid $350,000 at today’s market prices. For income tax purposes, the IRS would say that you had a “basis” in the house of $50,000 and a taxable gain on that house of $300,000. You would have to pay capital gains tax on that $300,000 of “profit.” At 15%, for example, the tax would be $45,000— leaving $305,000 for the children. However, if the house is your primary residence, you may be able to avoid taxation on all gain (up to $250,000, or $500,000 for a married couple).
Let’s say, however, that you never sell the house, but rather live in it until your death, and then leave it to your children as part of their inheritance. In that case, the house gets a “step up” in basis to the date of death fair market value. If the fair market value on the day of your death is $350,000, the “basis” is adjusted to that level. And if your children sell the house a month later for $350,000 there is no capital gains tax due. They were able to get the full value of the $350,000 inheritance.
When you gift your house to a QPRT, the remainder beneficiaries do not get a step-up in basis to your date of death value. The likely result is payment of capital gains tax when the children eventually sell the house.